A Synopsis of shadow banking in China

1. Cleopas Chiyangwa
Shadow banking in China
“A man who wants to lead the orchestra must turn his back on the crowd”. Max Lucado
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Banking & Finance
07 February 2014
TABLE OF CONTENTS

2. Introduction…………………………………………………………………………………………… 3-4
Trust companies financial products…………………………………………………………...4-5
China’s shadow banking trust products crisis case.………………………………..……..5-6
Risk homology of the shadow banking system in china………………………………..6
Conclusion……………………………………………………………………………………………...7
References……………………………………………………………………………………………..8
1. INTRODUCTION
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3. China’s financial system has undergone rapid financial innovation through securitization over the
years. Securitization is a process by which securities are created mainly linked to loan portfolios.
These assets are usually known as asset backed securities which are transformed into different
seniorities that are called tranches. The underlying loans are held by distinctive legal entities know as
special purpose vehicles (SPV) thus funding of loans by securitization activities is often known as
shadow banking. China’s informal and unregulated shadow banking system has grown rapidly in the
past two years, and now accounts for over one fifth of total credit in the economy. Lending by shadow
banks now totals Rmb47tn, or 84 per cent of gross domestic product, according to JPMorgan. The
accelerated growth of shadow banking in China has been caused by the incentives for lenders to avoid
tighter prudential regulations imposed on the formal banking system and efforts made by depositors
to shift from ordinary bank accounts to superior yielding wealth management products. However,
shadow banking system in China has played a useful function by channeling credit to profitable
businesses, especially SMEs that might otherwise have been credit constrained.
Shadow banking is defined as “credit intermediation involving entities and activities outside the
regular banking system” (FSB Report on Shadow Banking, 2012) & (European Commission Green
Paper, March 2012). It is also defined as, “a web of specialized financial institutions that channel
funding from savers to investors through a range of securitization and secured funding techniques”
(Adrian and Ashcraft, 2012).
Poszar et al (2010) envisaged that “Shadow banks are financial intermediaries that conduct maturity,
credit, and liquidity transformation without access to central bank liquidity or public sector credit
guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper
conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds,
money market mutual funds, securities lenders, and government-sponsored enterprises.” The
definition of shadow banking has been clearly mapped as below,
Figure 1 shows a definition of shadow banking and its various products.
Source: Joseph Tanega 2013 “Default Invariance: A Naïve Category Theory of Law and Finance”
The above map in Fig 1 is a novel that advocates that shadow banking can be transformed into
category theory terms as an isomorphism between assets flows and funds flows. And that is, real life
processes where maturity, credit and liquidity are transformed, and identities are preserved. B relates
to financial contracts that are relevant to shadow banking e.g. Repos, Asset Backed Securities (ABS),
Asset Backed Commercial Paper (ABCP) and Money Market Funds (MMMFs) (Tanega, 2013)
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4. According to Li and Hsu (2013) China’s shadow banking system comprises mainly of non-bank
financial products, including bank-trust cooperation financial products, products issued by trust
companies, financial leasing companies, quasi real estate investment trusts and credit risk assets; and
credit creation products often produced by small loan companies, investment companies, credit
guarantee companies, insurance brokerage firms, pawn shops, private equity investment funds, and
venture capital funds. The Chinese shadow banking system is dominated by commercial banks (in off
balance sheet transactions), insurance companies, and trusts. This paper will focus mainly on the bank
trust cooperation financial products.
2. TRUST COMPANIES FINANCIAL PRODUCTS
According to Reuters (2012), China’s trust sector is the third largest financial subsector, after the
banking and insurance subsectors, and possibly the riskiest. Trusts have encountered problems since
financial trusts are not subject to the same regulations that banks are subject to. Trust loans refer to
the loans of trust companies, which are prohibited from taking deposits, but which are authorized to
manage assets for enterprises and individuals. Trust companies can extend interest-bearing loans,
financed through various financial products sold to enterprises and individuals. A recent type of
financial product commonly used by trust companies are “bank-trust cooperation wealth management
products”, which are essentially notes issued by trust companies. Under this operating model, trust
companies sell various wealth management products to individuals through banks’ retail channels and
then use the proceeds to issue loans. Trust products are not guaranteed by banks however they are
attractive to individual investors as they offer attractive yields, usually yields well above bank deposit
rates which are capped by the central banking regulations. The following diagram shows the
operations of trust companies and banks in China
Figure 2. Shows the operation model of trust companies and banks in China
Source: BBVA Research 2012
The above schematic presentation shows that there is great interconnectedness between commercial
and trust companies, trusts could be set up either as cooperation between banks and trusts. Now
banks are forbidden from selling trust products due to the prevalence of default risk that encompasses
this particular product. Trust companies have skirted regulation that governs activity of commercial
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5. banks, and have often engaged in very risky activity. Wealth management products or trusts issued by
non-bank financial companies have attracted attention for investing in undisclosed or highly risky
projects.
According to (Forsythe and Sanderson (2011), envisaged that trusts also invest in local government
and municipal bonds are also at risk since these products are based on underlying assets that may not
generate an equivalent cash flow. Trust companies usually indulge in poor real investments for
example the product called Golden Elephant No. 38 was based on investment in a near to empty
housing project in a poor, rural Taihe, while another product invested in a coal company, Zhen Energy,
was at risk of default because the coal company owner was unable to repay loans (Reuters 2012).
Another trust product is Quasi-Real Estate Investment Trusts (Q-REITs) incorporates risk based in
large part on the underlying real estate assets which is an imminent factor. Currently, the Chinese real
estate market is experiencing a boom and a corresponding bust which is major exposure to risk. As of
2011, the real estate trust average yearly returns ratio was as high as 10.09%.
According to (China Business News (2011), China’s real estate trust products are in their initial stages
of development and growing rapidly. However, their rapid growth is subjected to poor risk
management consequently the Q-REIT business carried out by four major trust companies was
ordered to be temporarily suspended due to lack of prudence in selecting feasible investment
programs.
2.1 CHINA’S SHADOW BANKING TRUST PRODUCTS CRISIS CASE
Recently there has been so much attention on the products of shadow banking in China since their
macroeconomic risk altitude might prompt financial distress and insolvency on the global financial
system. According to Gordon (2010), advocated that the wholesale banking panic in the shadow
banking system caused the financial crisis in August 2007.
Credit Equals Gold No. 1, is the Chinese investment product that was rescued from the brink of failure
a case where the government injected more liquidity in the financial system. High quality global
journalism requires investment. According to Financial Times (January.31.2014) in 2011, China Credit
Trust loaned Rmb3bn to Wang Pingyan, a coal mine operator in the northern province of Shanxi. In a
speculative move Mr. Wang unfortunately decided to scale up the investment dramatically just as coal
prices peaked. The company collapsed soon after receiving the loan leading to the default. The Credit
Trust pitched the loan as a product with an anticipated annual return of ten percent instead of selling
it directly the product was marketed by Industrial and Commercial Bank of China, the country’s largest
lender, to wealthy private banking clients. On default this sparked a major controversy about who
should assume responsibility since the Industrial and Commercial Bank of China did not guarantee the
loan. The developments of the case presents a risk homological structure where the Credit Trust and
the Bank could not a fully apply and comply initial contractual terms to clarify the claimant
contingencies. In this case the risk homological structure is an isomorphism between a issuing of
funds into the shadow banking system, the risk quantification by the bank and the marketing the
product to Mr. Wang. Given the following a risk homology of the shadow banking system can be
assessed.
3 RISK HOMOLOGY OF THE SHADOW BANKING SYSTEM IN CHINA
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6. The risks hidden in China's domestic financial system will remain undetected unless housing prices
drop. Usually, systematic risks for many financial systems are not easy to predict unless the risk levels
has reached a certain threshold. This can be illustrated by the fate of China’s $5 trillion shadow
banking system that has been hanging on a $469-million investment vehicle that looked in danger of
defaulting. The above given case shows that the annihilation of uncertainty is not possible as a result
the government is gradually becoming the primary pump to shadow banking. The events currently
faced by the Chinese shadow banking relates to assumption three of the Default Invariance theory
where nonpayment or default of the trust product implies a law of distributivity which forms default
invariance cycle. There is a gap between contract formation and settlement as a result of financial
innovation which ends up as a bail out by the government. This can be illustrated by the diagram
below;
Source: MBA Banking Foundation class notes
The above matrix applied to initiates with (I/I) where there is morale failure as a result there is
creation of high quality assets that will be issued in the form of debt instruments through shadow
banking and there is no government reliance this applies to when the Credit Equals Gold No. 1 product
was created, (I/B) denotes a generalized default where the government implements quantitative
easing. The Chinese government is covering shadow banking taking over most defaulted trust
products. The Chinese Central bank has been advocating for strict
4. REGULATION OF THE TRUST COMPANIES
Trust loans have received relatively more attention from the authorities since their activities have
exceeded those of commercial banks. This is partly because of a high profile trust company bankruptcy
scandal in 1998 in which the government had to intervene to liquidate the insolvent Guangdong
International Trust and Investment Corporation. Despite concerns with trust company lending,
however, until recently regulators refrained from imposing capital requirements on such activities
which created incentives for banks to channel their lending through off-balance sheet activities
facilitated by trust companies.
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7. 5. CONCLUSION
Shadow banking has played a big role in the financial system of China, Given the rapid development of
the shadow banking system in China; financial disintermediation has rapidly increased, potentially
causing financial fragility and sheer concern. Shadow banking institutions creates a vast contingent of
new products daily however; these products are not effectively monitored by regulatory sectors. The
risks of shadow banking system are escalating under the background of the global economic
downturn. Government guarantees to public bonds, publicly owned banks and other financial
institutions may intensify moral hazard which would cause systematic risk which is currently showing
within the Chinese economy. Consequently, it is necessary to establish a new financial regulatory
system to adapt to the development of the shadow banking system.
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8. 6. REFERENCES
Adrian, Tobias and Ashcraft, Adam B., Shadow Banking Regulation (April 1, 2012). FRB of New York
Staff Report No. 559.
BBVA Search Hong Kong Banking Watch 2011
China Business News. 2011. China Banking Regulatory Commission Requires Four Trust Companies to
Suspend REIT Operations. China Business News, October 20.
Gordon, Gary, (2010), Questions and Answers about the Financial Crisis. Unpublished text prepared
for the U.S. Financial Inquiry Commission, February.
Financial Times. 2014. Economic danger lurks in China’s shadow banks
FSB Report on Shadow Banking 2012
Forsythe, Michael and Henry Sanderson. 2011. China Debts Dwarf Official Data With Too-Big-To-Finish
Alarm. Bloomberg, December 18.
Joseph, Tanega, 2013 “Default Invariance: A Naïve Category Theory of Law and Finance”
Pozsar, Zoltan (2010): “Institutional Cash Pools and the Triffin Dilemma of the US Banking System,”
IMF Working Paper No. 11/190.
Reuters. 2012. New Investment Products in China Raise Fears of Collapse. The New York Times.
August 7.
Li, Jianjun and Sara Hsu. 2009. Informal Finance in China: American and Chinese Perspectives. New
York: Oxford University Press.
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